Session 2 - Goals, Value & Performance PDF

Strategies for Competing in Industries and Markets Session 2 Value creation and capturing  Agenda Besanko Book - Chapter 9 - Pages 278-292 Competitive Advantage and Value Creation: Conceptual Foundations Grant Book, Chapter 2, Goals, Value...

Strategies for Competing in Industries and Markets Session 2 Value creation and capturing  Agenda Besanko Book - Chapter 9 - Pages 278-292 Competitive Advantage and Value Creation: Conceptual Foundations Grant Book, Chapter 2, Goals, Values & Performance Strategy as a Quest for Value Putting Performance Analysis into Practice Beyond Profit: Values and Corporate Social Responsibility Beyond Profit: Strategy and Real Options  Agenda Besanko Book - Chapter 9 - Pages 278-292 Competitive Advantage and Value Creation: Conceptual Foundations Grant Book, Chapter 2, Goals, Values & Performance Strategy as a Quest for Value Putting Performance Analysis into Practice Beyond Profit: Values and Corporate Social Responsibility Beyond Profit: Strategy and Real Options Competitive Advantage and Value Creation: Conceptual Foundations Framework for Competitive Advantage. Figure 9.2 (Besanko) Competitive Advantage and Value Creation: Conceptual Foundations Defining Value Creation B = Max. willingness to pay Consumer Surplus P = Price B-P Value C = Costs Producer surplus Creation P-C B P Costs C C Value Created = Consumer surplus + Producer surplus Or Value Created = ( B - P ) + ( P - C ) = B - C Competitive Advantage and Value Creation: Conceptual Foundations WTP is somehow an intangible (depends on consumer) A firm’s WTP for an input is easier to quantify, for instance Value-added analysis - The difference between the value of the firm’s output and the cost of its material inputs Source: Besanko Book Competitive Advantage and Value Creation: Conceptual Foundations Source: Besanko Book Can a company create value, but struggle to capture it? Competitive Advantage and Value Creation: Conceptual Foundations  Competitive Advantage and Value Creation: Conceptual Foundations Points on the indifference curve represent price- quality with the same consumer surplus The steepness of the indifference curve reflects the tradeoff between price and quality that the consumers are willing to make Source: Besanko Book Products A and B exhibit consumer surplus parity Product C has a higher consumer surplus than A and B Product D has a lower consumer surplus Competitive Advantage and Value Creation: Conceptual Foundations In conclusion.. Consumer surplus needs to be positive for B - C > 0 product is economic viable the purchase to occur. B - P > 0 However, B - C > 0 does not imply Profit > 0 If there is a choice between two or more (i.e. When Price equals Cost, no Firm Surplus) products consumer will choose the one with the largest consumer surplus. In order that Profit > 0 of Firm 1 in a competitive industry: Thus, the first step for firms to compete B - C of Firm 1 > B - C of Firm 2 successfully is to delivering consumer surplus. B - C large enough that competitors cannot generate it and duplicate it. The difference between the value of the firm’s output and the cost of its material inputs The firm with the highest competitive advantage in the competition is the one with highest B - C  Agenda Besanko Book - Chapter 9 - Pages 278-292 Competitive Advantage and Value Creation: Conceptual Foundations Grant Book, Chapter 2, Goals, Values & Performance Strategy as a Quest for Value Putting Performance Analysis into Practice Beyond Profit: Values and Corporate Social Responsibility Beyond Profit: Strategy and Real Options Strategy as a Quest for Value Value creation as organizational purpose Organizations exist for a purpose Organizational purposes vary considerably and are beyond making money Common denominator: The desire and need to create value Strategy as a Quest for Value Value creation and distribution Two ways of value creation: Production (physical transformation of products) Commerce (reposition products in space and time) How is the value added distributed? Stakeholders − Employees (salary and wages) − Lenders (interest) − Landlords (rent) − Government (taxes) − Owners (profit) − Customers (consumer surplus) Debate about whether firms should maximize shareholders‘ or stakeholders‘ interests „enlightened shareholder value maximation … is identical to enlightened stakeholder theory“ (Jensen, 2010) Putting Performance Analysis into Practice Is Porsche a successful firm ? Putting Performance Analysis into Practice Is Porsche a successful firm ? What “metrics” help us understand business success? Putting Performance Analysis into Practice Putting Performance Analysis into Practice How can we measure firm’s ability to create / capture value? Which are the metrics to check how a firm can create/capture value? The main sources of data are corporate balance sheets and data coming from stock exchanges (market value) A good way to organize the analysis is dividing measures into 1. Backward-looking performance measures: based on balance sheets 2. Forward-looking performance measures: based on the stock market values Putting Performance Analysis into Practice Backward-looking Profitability Ratios Short term measures Source: Grant Book, Chapter 2 Putting Performance Analysis into Practice Backward-looking Profitability Ratios Short term measures The main source of data in this respect are corporate balance sheets Classical measures are: – ROI = EBIT/ (FA + (CA – CL)) – ROA = EBIT / TA – ROE = NET INCOME / EQUITY In each measure, the numerator is a measure of the firm’s ability to generate profits from its operations – ROE accounts for the capital invested by the shareholders, – ROA includes all the assets – ROI denotes Fixed Asset and Positive/Neg Working Capital All measures lead to consistent results, they can vary for the weight of equity or debt and much more across sectors Putting Performance Analysis into Practice Backward-looking Profitability Ratios Short term measures A nice way to decompose the ROI ROI = (EBIT / (FA +WC)) x SALES/ SALES = (EBIT/SALES) x (SALES /(FA + WC)) = ROS x CT ROS = Returns on Sales CT = Capital Turnover Putting Performance Analysis into Practice ROS, Value Capture and Value Creation ROS=(EBIT/SALES). It measures how many profits the company is able to generate given its sales. It is a good proxy of efficiency of operations, because you can note that you have a sales component both in the numerator and in the denominator, but in the numerator you have also the cost of good sold component. This is why it could be read as a good measure of value capture. CT=(SALES/(FA + WC)). It is the Capital Turnover, which represents how many sales a company it is able to generate given the capital invested. This measure tends to vary greatly with industry characteristics because industries that require more capital tend to have a higher denominator. Usually industry with CT lower than 3, meaning that sales are less than three times the capital invested, tend to be dominated by large firms. Values higher than 3, we could start talking about a fragmented scenario. This is why it is a good proxy of value creation, meaning how many sales and volume you are able to generate given your capital. But no cost proxy is inside this measure. Putting Performance Analysis into Practice Forward-looking (long-term) measures 𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡h𝑒 𝑓𝑖𝑟𝑚 = 𝑠𝑡𝑜𝑐𝑘 𝑝𝑟𝑖𝑐𝑒 ∗ 𝑛𝑏. 𝑜𝑓 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝑠h𝑎𝑟𝑒𝑠 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡h𝑒 𝑓𝑖𝑟𝑚 𝑇𝑜𝑏𝑖𝑛′𝑠 𝑄 = = 𝑟𝑒𝑝𝑙𝑎𝑐𝑒𝑚𝑒𝑛𝑡 𝑐𝑜𝑠𝑡𝑠 𝑜𝑓 𝑡h𝑒 𝑎𝑠𝑠𝑒𝑡𝑠 (𝑏𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒) 𝑆𝑡𝑜𝑐𝑘 𝑝𝑟𝑖𝑐𝑒 ∗ 𝑛𝑏. 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘𝑠 + 𝑑𝑒𝑏𝑡 − 𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠 + 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 – Q > 1, the firm’s value is higher than its tangible assets, the evaluation of its intangible assets is positive – Q < 1, there is something wrong, the market values the firm less than its tangible assets – For comparing firms: Tobin‘s Q is more suitable – Disadvantage of stock-based measures: Market inefficiency (e.g. market psychology) Putting Performance Analysis into Practice From profit maximization to value maximization (1/2) Maximizing the value of the firm: – Max. net present value of free cash flows: V = market value of the firm Ct = free cash flow in time t WACC = weighted average cost of capital To maximize its value, a firm must maximize its future net cash flows while managing its risks to minimize costs of capital Putting Performance Analysis into Practice From profit maximization to value maximization (2/2) If cash flows grow at a constant rate the net present value can also be calculated as: 𝑔 𝑁𝑃𝑡=1(1 − 𝑅𝑂𝐼𝐶 ) 𝑀𝑎𝑥 𝑉 = 𝑟−𝑔 𝑉 = value 𝑁𝑃𝑡=1= cash flow from net operating profits after taxes 𝑔 = yearly growth rate of net operating profits 𝑅𝑂𝐼𝐶 = return on invested capital (that is = P / cumulative invested capital r) Implication: – g and ROIC are backward looking measures – Used to caculate forward-looking measure Putting Performance Analysis into Practice Different Ratios, Different Profitability Source: Grant Book, Chapter 2 Putting Performance Analysis into Practice Essential steps for a strategist to evaluate a firm’s profitability 1. Avoid basing any firm evaluation on just one measure Triangulate different measures Analyze performance measures longitudinally 2. Be careful when comparing measures of firms operating in different sectors Across-sector comparisons may lead to inaccurate conclusions 3. Take into account that firms can be multi-business organizations They are competing in different sectors and countries 4. Be aware that financial measures are subject to several measurement errors They must be complemented by additional information about a firm’s strategy Putting Performance Analysis into Practice Performance and strategy development 1. Appraising of current and past performance – Forward–looking measure: Stock market value (volatile!) – Backward–looking measure: Accounting ratios (benchmarking useful!) 2. Performance diagnosis – Identify sources of poor performance 1. Using performance diagnosis to guide strategy formulation – Disadvantage: Based on historical information 2. Setting performance targets – Financial disaggration – Balances score card – Startegic profit drivers